Investors Keep Faith in Euro Zone

By Neelabh Chaturvedi

This week’s moves in bonds sold by fiscally-frail euro zone countries suggest that financial markets have more faith in the systems put in place to secure the euro zone’s future than the Italian electorate does.

It’s still early days and developments in the typically volatile world of Italian politics could yet rumble markets, but the sell-off in Italian bonds so far has been less intense than previous bouts of panic in debt markets. The yield on Italy’s benchmark 10-year bond is up only 0.40 percentage points (but has fallen in the past two days) since the election results on Tuesday.

That compares with a much steeper 1.0 percentage point increase in yields in the week running up to former Prime Minister Silvio Berlusconi’s ouster. Greek bond yields had soared by 10 percentage points after a similarly inconclusive election in Greece last year which, like Italy’s this week, was dominated by a surge in the protest vote and left no party with enough seats to lead a government.

Although its borrowing costs climbed to a four-month high at a bond sale on Wednesday, Italy managed to sell the maximum intended amount. The yield offered to investors on a 10-year bond was well below levels indicated in the unofficial market just a couple of hours before the auction. Spanish bonds, which had been infected by the concerns over Italy in the past, have also recovered a big chunk of their losses. This suggests the measures in place to save the euro zone have prevented troubles in Italy contaminating other vulnerable countries in the region.

That’s not to say all is hunky dory. Political paralysis will likely imperil efforts to reform an economy that had struggled to grow even before the euro zone debt crisis exploded. Rating agencies may lower Italy’s debt rating further (although, for the moment, the bonds still comfortably qualify as investment grade).

Swiss bank UBS reckons that the rally in Italian bonds is likely over and yields could start climbing sharply higher. The bank’s head of European rates strategy, Justin Knight, notes that many investors still hold higher numbers of Italian and Spanish bonds relative to their weighting in the bond benchmarks the investors follow.

“Higher yields and/or higher volatility will likely stop many investors from taking long positions in peripheral markets at this stage, and have the potential to trigger selling by those who already have,” Mr. Knight says.

But the tentative recovery in Italian bonds suggests at least a few market participants are still giving policymakers the benefit of the doubt.

Some believe that the European Central Bank might show a little more flexibility in showing its commitment to keep a lid on Italian borrowing costs, even if it doesn’t end up actually using its Outright Monetary Transactions bond purchase program.

The program is intended for fiscally-frail euro zone countries provided they agree to a monitored program to cut costs and revamp their economies and its presence alone has helped underpin riskier euro zone debt. Italy’s fiscal position is now better than most euro zone countries, so any cost-cutting demanded by creditors is likely to be less severe while the plentiful cash in the banking system needs to find a home as well.

For some, simply the possibility of large-scale bond purchases by the ECB may act as a deterrent against selling Italian bonds too aggressively.

“The ECB has shown throughout the crisis that it is more than willing to take action when politicians hesitate in order to keep the euro zone together,” says Lyn Graham-Taylor at Rabobank International.

“Given this we feel that that the ECB would loosen the conditionality rule of the OMT if it had to,” Mr. Graham-Taylor said.

As it is, the 10-year Italian bond yield at 4.77% is comfortably below the euro era highs of near 7.50% reached in November 2011 so bonds would have to plunge precipitously to force Italy into seeking assistance. A further increase in bond yields may even entice return-starved asset managers and pension funds.

Comments (1 of 1)

I think that there may be another explanation for the absence of a spike in Italian yields, and that could be a belief among investors that whatever Government Italy gets will be so dependent on the ECB that it simply has to do whatever the ECB tells it to do.

In other words, the euro crisis may already have achieved what a lot of people have predicted, which is that without sovereign currencies, national Governments in the euro-area just don't have the power or relevancy any more that they used to have, and the ECB itself has become a major political player, capable of setting and enforcing fiscal policy over any purely national objections.